Industries

Peering over the fiscal cliff

Will defense budget cuts become a myth or a monster?

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Print this page by Tim Loughran

A big red clock on the Aerospace Industries Association (AIA) website http://www.secondtonone.org counts down the seconds to   Jan. 2.

That is the current trigger date for “sequestration,” the awkward name for automatic budget cuts that would cut 10 percent from the $5 trillion the U.S. plans to spend on non-combat, national defense operations through 2021.

For more than a year, AIA and its members — which include Virginia-based defense contractors General Dynamics, CSC, ITT Exelis, Northrop Grumman, Huntington Ingalls and SAIC — have pushed Congress to delay or cancel the cutbacks, which would total about $500 billion over the nine-year period.  The cuts were required by the 2011 Budget Control Act (BCA), a compromise enacted reluctantly by Democrats and Republicans to raise the federal debt ceiling and avoid default on government debt. The law also called for another $500 billion cut in spending on domestic programs.

In congressional testimony, newspaper columns, research reports and pep rallies, the defense industry has warned that full implementation of the law could cripple air travel, reduce economic output, push the nation into recession and eliminate millions of jobs, including more than 200,000 in Virginia.

The Pentagon budget already has been reduced by $487 billion through 2021 by an initial wave of cuts mandated by the BCA. Defense Secretary Leon Panetta has said the additional cuts pose “doomsday” risks for the country’s national security.

AIA President Marion Blakey has asked why the Pentagon, responsible for just 20 percent of the federal budget, is being asked to bear 50 percent of the spending cuts. She says the BCA will spark an “unemployment Armageddon” in almost every sector of the economy, eliminating jobs at a rate of 175,000 a month throughout next year.

Skeptics think these dire warnings are overwrought. But a chorus of defense industry executives, political pundits and economists say they don’t believe the Pentagon will be forced to slash its budget much, if at all.  Lawmakers, they say, will pass a continuing budget resolution to postpone the cutbacks sometime after the Nov. 6 election but before the new Congress takes office in January. Democrats and Republicans alike can’t risk too much more talk about a spike in unemployment or another downturn in the economy.

“Some way or another [lawmakers] are going to defer this until March or April of next year,” says Stephen Fuller, director of George Mason University’s Center for Regional Analysis in Fairfax, which prepared a report detailing the economic consequences of the cuts for the AIA. “They have to do something. They have to negotiate. They have to compromise.”

Meanwhile, the rhetorical tug of war continues in Washington. In a September report describing the across-the-board cuts as “deeply destructive” to the military and core government functions, the White House restated its call for a partial repeal of the tax cuts enacted during the George W. Bush administration. The Obama administration told the Republican-controlled House of Representatives it prefers “enactment of bipartisan balanced deficit reduction legislation” to Pentagon spending cuts. 

Virginia’s Rep. Eric Cantor, the House majority leader, replied, “It remains incumbent on President Obama and Senate Democrats to take serious action to prevent these arbitrary, devastating cuts from taking place.”

If sequestration does take effect, the defense industry is not out of luck. Congress still will have options to reduce defense cuts through its power to manipulate the federal budget. Also, analysts say contractors likely would not see the full effects of cutbacks for months if not years because they would not stop payments on contracts already awarded. Nonetheless, the wrangling over the defense budget appears to mark the start of a new era in the relationship between defense contractors and the Pentagon.

$54 billion in Virginia
The domestic and defense budget cuts in the BCA represent only one of the obstacles lurking at the “fiscal cliff, ” a term coined by Federal Reserve Chairman Ben Bernanke to describe the dilemma facing Congress at the end of this year. Federal tax cuts are due to expire at that time. If Congress takes no action, the combined effect of the budget cuts and higher taxes could push the U.S. into recession, according to the Congressional Budget Office.  On the other hand, if some or all of the tax increases and budget cuts are eliminated, federal spending could soar, adding to the deficit.

Virginia is no idle bystander in this debate. Companies in the commonwealth held nearly 59,000 defense contracts last year worth more than $54 billion, according to the Washington-based Center for Security Policy (see chart). The biggest concentrations of contracts were in Northern Virginia and Hampton Roads.

A study for the AIA conducted by the GMU Center for Regional Analysis (CRA) in partnership with Richmond-based Chmura Economics & Analytics predicts total cuts to defense and nondefense agencies under sequestration would cost the economy 2.14 million jobs within 12 months and reduce gross domestic product by $215 billion. The defense cuts, however, would not cause U.S. base closures or affect military pay. (Another analysis by the CRA in October 2011 focusing only on procurement of military equipment and research and development spending estimated job losses nationwide would total more than 1 million.)

The latest CRA study estimates Virginia would lose 136,191 jobs because of defense cuts while cuts to nondefense spending would reduce payrolls by 71,380. The Virginia job loss total, 207,571, would rank second only to California’s estimated losses of 225,464 jobs.

But Veronique de Rugy, a senior research fellow at GMU’s Mercatus Center in Arlington, is skeptical of these high job-loss estimates. She offers a dissenting view on budget cuts, noting that, adjusted for inflation, national defense spending under the first year of sequestration would revert to its 2007 level.

In her analysis of the BCA’s impact on future spending, de Rudy used National Defense spending, a federal budget category, It includes spending for many military-related items that are outside the Department of Defense but are considered defense spending under the Budget Control Act. Among other things, this list includes nuclear weapons research and production, Treasury Department payments for military pensions; interest on debt incurred in past wars; State Department financing of foreign arms sales and militarily-related development assistance.

The Department of Defense budget makes up about 95 percent of the total in this category. Excluded from this group, however, are war costs, known as Overseas Contingency Operations or OCO.

According to de Rugy, national defense spending hit $560 billion in fiscal year 2010. It fell to $552 billion in 2011 and to $538 billion in FY 2012, which ended on Sept. 30.

With sequestration, she says, spending would fall to $492 billion in FY2013 (which began Oct. 1), rebound to $502 billion in 2014, rise to $549 billion by 2018 and reach to $590 billion in FY2021. If sequestration is avoided, spending will rise to $541 billion in the next 12 months, return to $560 billion in 2015 and reach almost $640 billion in 2021.

National defense spending currently is on track to rise about 2 percent every year through 2021, or a total of $5.27 trillion, according to de Rugy. If sequestration cuts are fully enacted — which de Rugy doubts will ever happen — the budget still would increase by an annual average of about 1 percent to $4.84 trillion.

“Defense spending has almost doubled in the past decade in current dollar terms and will continue to grow in spite of automatic cuts set by the BCA,” de Rugy wrote in a recent analysis. “Clarifying these figures reveals that sequester cuts do not warrant the fears of policymakers who warn about ‘savage cuts’ to the defense budget.”

In constant (2013) dollars, however, growth of the Department of Defense budget alone would remain low, rising only 2.7 percent from $521 billion in 2013 to $535 billion in 2021 before sequestration, according to the Congressional Budget Office.  If sequestration is implemented, spending would drop to $469 billion in 2013 before increasing 4.3 percent to $489 billion by 2021.

Congress can blunt the effects of sequestration by adjusting the amount of money going to war funding (OCO), de Rugy says. “Congress can set the level of OCO spending above and beyond what is needed in anticipation of the impact of the sequester and caps on defense spending,” she wrote.

In fact, beefing up war funding but not actually spending the money on combat operations is one of a number of ideas explored in an August article in Washington-based CQ Weekly looking at ways to take the sting out of defense cuts.  “Lawmakers and executive branch officials have a variety of tools that would allow them to wield the sequester as a scalpel rather than an ax,” the article said.

In addition to using war funding money to relieve pressure on the core defense budget, another tactic would be to alter the definition of certain funding categories in the budget. Cuts are slated to affect spending at the “program, project and activities level.” Congress simply would change the identification of certain types of spending to give itself more flexibility, U.S. Rep. C.W. Young, a Florida Republican, told CQ Weekly.

Likewise there is “reprogramming,” a process that allows the Pentagon to shift money within its budgets from low-priority projects to more important programs.

The Graham-Rudman-Hollings law also includes a section allowing the White House to come up with an alternative plan for meeting sequester requirements. “I haven’t a clue as to why no one is talking about this. It’s a mystery to me,” Gordon Adams told CQ Weekly. He was in charge of the Pentagon budget at the Office of Management and Budget under President Bill Clinton.

Major firms to stay profitable
The defense industry has prospered in the past decade as Congress ramped up spending to counter terrorism and fight wars in Iraq and Afghanistan. According to Forbes magazine, the total profits posted by the five-largest U.S. defense contractors — including Falls Church-based General Dynamics and Northrop Grumman, along with Lockheed Martin, Boeing and Raytheon — have more than tripled since the 1990s, to $24.8 billion from $6.7 billion.

Earlier this year a Bloomberg News survey of Wall Street firms covering the defense industry reported that this same group of companies should see almost $13 billion in profits during 2013, up from an estimated $12.3 billion during 2012, a year when core Pentagon spending fell by 2.5 percent from 2011.

While decrying the potential damage that sequestration could do to their industry, executives at some major defense contractors have reassured investors that their companies will remain strong. Wes Bush, CEO of Northrop Grumman, and John Jumper, the chairman and CEO of McLean-based SAIC, are two examples.

In a May conference call, Jumper told institutional investors and Wall Street analysts, “Despite the budget decisions ahead, there will remain a large national security marketplace available to SAIC to compete, and we expect to be in good position to do so.” (SAIC announced in late August that it plans to split itself into two separate, publicly traded companies, one focused on technical services and the other on science and technology solutions.)

In July, Bush told investors during the company’s second-quarter conference call that Northrop Grumman was well prepared for any budget contingency. “I want to be clear that we will be ready to address the environment should [sequestration cuts] occur ... we’re going to be ready.”

Later that month, Jumper and Bush appeared at a Northrop Grumman-sponsored “Stop Sequestration” rally in a Crystal City hotel ballroom attended by Virginia congressmen, Gov. Bob McDonnell and 300 cheering, sign-waving employees. The CEOs warned that, because of looming budget cuts, highly trained workers would look outside the defense industry for income security. “When that talent vanishes, it’s hard to build back up,” said Jumper in an interview with the Washington Business Journal.

(Jumper could not be reached for comment, and Bush, through company media representatives, declined interview requests.)
A possible factor in defense contractors’ expected 2013 profits is the time lag between the implementation of budget cuts and their effect on payments to contractors. The Washington, D.C.-based Center for Strategic and Budgetary Assessments says that, while sequestration would slow the Pentagon’s ability to award new contracts immediately (and cause the layoff of more than 100,000 Defense Department workers), it would not stop payments on contracts that already have been awarded.

As a result, many defense contractors would not feel the full effects of sequestration for possibly three to four years.  “This gives the industry more time to adjust employment levels through natural attrition and early retirement rather than forcing immediate layoffs,” the study says.

Fiscal Times magazine echoed the findings of that report. Quoting defense industry consultant Loren Thompson of the Lexington Institute, the publication said in mid-July, “The BCA cuts in budget authority will take years to translate into lower spending. The impact will dribble out over four or five years.”

Deficit reduction an issue
Why, after so many years of steady increases, is the U.S. defense budget under fire?

Deficit hawks in Congress have focused on the Pentagon for several reasons, including a lackluster economy and the winding down of unpopular conflicts in Iraq and Afghanistan. Both political parties, based on the GOP’s thrashing of Democrats in the 2010 midterm elections, also realize that deficit reduction now is a powerful political issue.

Under President George W. Bush, increased Pentagon spending helped revive the stumbling U.S. economy after the 9/11 terrorist attacks. That spending was continued by President Obama as he tried to rebound from the Great Recession, which officially ended in June 2009.

In fact, for much of the past 70 years both Democrats and Republicans in Congress routinely approved higher Pentagon budgets as a way to keep Americans working. As Northrop Grumman’s Wes Bush told one reporter in July, “Fundamentally, the nation does well when its defense industry is financially healthy.”

A bitterly divided Congress took full aim at the federal deficit and Pentagon spending in summer 2011 when Democratic and Republican lawmakers agreed, grudgingly, to pass the BCA. 

One provision of the new law required a “supercommittee”’ of 12 lawmakers from both parties to trim another $1 trillion from the federal budget through tax increases, spending cuts or a combination of both. If that committee failed to deliver, Congress authorized the White House to slash $984 billion in federal programs starting in 2013. (The widely quoted figure of $1.2 trillion includes interest payments.) Half of this second round of federal spending cuts would come from the Pentagon.

Double-barreled challenge
Unfortunately for some U.S. defense contractors, they face a double-barreled challenge in the years ahead.

Analysts say Congress no longer has the power to force the Pentagon to buy weapons systems that employ the most voters. For the next decade annual increases in Pentagon spending will shrink to between 2 and 3 percent, down from an average of about 10 percent during the past 10 years. At the same time, America’s generals and admirals want to fight the nation’s wars differently and have said they will not buy what they do not need. 

Focused now on possible conflicts in the Middle East and East Asia, the Defense Department wants to leverage and further enhance the technological advantages the Navy and the Air Force now possess over every other nation on the planet.

It wants to buy more sophisticated computer hardware and software, better communications, surveillance and electronic warfare technology, more precise tactical missiles, more advanced, fuel-efficient aircraft (manned and unmanned) as well as smaller, lighter, speedier ships that can transport and support smaller groups of special forces units in anti-terrorist operations and other low-intensity conflicts.

To meet the first round of $487 billion in future cuts to Pentagon spending approved by Congress in August 2011, the Defense Department announced in January that it plans to trim the number of active-duty Marines by 20,000 and the number of combat-ready Army troops by 80,000 by 2017.  Seven of the Navy’s aging Ticonderoga-class warships are on the chopping block as well. The Air Force has been asked to ground six of its 60 tactical fighter squadrons, sharply curtail purchase of the costly new F-35 fighter, mothball 150 military supply aircraft and discontinue funding some models in the Global Hawk drone program.
As Joint Chiefs of Staff Chairman Gen. Martin Dempsey said almost a year ago, “Capability is more important than size … This budget does not lead to a military in decline. Rather, it matches capabilities to needs.”

One company that has first-hand experience with the Pentagon’s latest experiment with austerity is General Dynamics. Earlier this year in two successive quarterly earnings presentations, Jay Johnson, president and CEO, repeated his forecast that the short-term outlook for his firm’s products and services is mixed.

In both conference calls Johnson reported that what he called the usual “fog bank” of Washington, D.C., budget politics had led to delays in the Pentagon’s awarding of several new contracts for information systems and technology projects that his executives were hoping the company already would have won. Last April, according to a transcript of his remarks, Johnson said that while continued funding for the company’s Stryker attack vehicle and its Abrams tank were in doubt, he and his team were “generally pleased with the support [from the Pentagon] for our shipbuilding and technical communications program.”

Faced with what may be severe cutbacks to the controversial F-35 fighter project, called one of the most expensive weapons systems projects in history, Northrop Grumman already has begun plans to diversify its offerings to the Pentagon. Northrop Grumman and BAE Systems are principal partners with manufacturer Lockheed Martin in the fighter project.

Bush told investors and Wall Street analysts in July that regardless of future budget cuts at the Pentagon, the company’s future sales and manufacturing efforts in the defense arena will be in four areas: unmanned weapons (including drone aircraft and anti-IED bomb disposal robots), cyber warfare, logistics services for weapons systems and “C4ISR,” a common industry acronym for “Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance.”

“That’s where we try to get inside of the decision cycle of the bad guys and head it off at the pass,” says company spokesman Randy Belote.

Belote said the company’s main product lines are known within the company as “the four pillars,” and are the result of what the Pentagon has asked the industry to provide in the years ahead. “These are areas we believe are well aligned with our customer’s core priorities.” 


SEQUESTRATION:

What would be affected

Department of Defense (DoD) contractors

  • Reduction in new contract awards, contract extensions, options, etc.
  • Would likely force DoD to renegotiate contracts to buy in smaller quantities and cause unit costs to rise
  • Could cause DoD to reconsider continuing some acquisition programs in the future

DoD civilian employees

  • Paid directly by government, nearly all budget becomes outlays in first year
  • Reduction of roughly 13.7% (108,000 jobs) in final 9 months of FY13 would be needed to achieve a 10.3% reduction in budget authority

Would slow down nearly everything DoD does: military construction, training, peacetime operations, etc.

What would not be affected

No base closures
2 U.S. Code, § 907c (b): “No actions taken by the President … may result in a domestic base closure or realignment that would otherwise be subject to section 2687 of title 10, United States Code.”
No “pink slips” for active, guard, or reserve military personnel

  • Reductions already planned could continue

No reductions in pay for military personnel

  • Basic pay, allowances for housing and subsistence, retirement pay, special pays and bonuses would not be affected by sequestration
  • One notable exception: military health care funded through Operation and Maintenance budget

No immediate program terminations

  • Funding already obligated on contracts would not be affected

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